The American Economy and Condo Pricing

It is now impossible to open a newspaper, turn on a television or crack open a business magazine without hearing or reading about the impending collapse of the US real estate market. Unfortunately, due to our proximity to our southern neighbours, our real estate environment is also coming under scrutiny. Of course the rhetoric is nothing new. I can't recall a week where some expert wasn't predicting an impending disaster. Despite the need for the media to feast of a plague, stride and collapse, there is something to be said for what definitely should be categorized as a softening in the US. What is going on in the United States? Will Canada be affected? Cities like Phoenix, Los Angeles, New York, Miami, Boston, Chicago, Las Vegas and San Diego are experiencing a real slowdown in sales of new and resale homes. New home sales (high-rise and low-rise) are down after record years. Why are sales faltering? In some cities prices are starting to fall. I believe there are several factors at work. Lending rates are too high. Lending practices are too easy. Prices in many cities have become ridiculous.

The supply of housing has increased to levels not seen in years. The US economy is experiencing some inflation and huge government deficits, along with potentially rising unemployment and rising interest rates. Some markets have unusual influences and unstable situations. All of these things are problems for the US real estate market and collectively they are making it difficult to be a seller today.

The Fed raised its benchmark rate 17 consecutive times from 1% to 5.25% over two years. The goal was to cool off a hot economy but not entirely kill it. They have cooled it off. Rates have stabilized and will shortly start to fall again. The interest rate situation will start to re-stimulate residential real estate by the fall of 2008 when the Fed starts to lower rates to help the economy. However, these rate increases have done the trick. The US housing market is cooling. The fact that 25-30 years amortizations came along is a good thing. The longer amortization allowed more buyers to afford the payments. A zero equity loan is a bad thing. If you don't have the scratch you shouldn't be in the game. This kind of loose lending has made it too easy to buy a property, and has allowed marginal buyers to get into property ownership. The problem with a zero equity buyer is that they have no buffer for a drop in home values. If you're under water by $20,000 with no money down, it's too easy to walk away. This is going to happen in the US in some situations.

When I found out that luxury condo prices in Las Vegas rose to over $1,000 per square foot I couldn't help buy shake my head. There is so much land available in Vegas that pricing at that level doesn't make any sense. At least in Manhattan the island is finite and land is scarce. Manhattan has a problem with too large of a spread in pricing on luxury housing.
One location could be $800 per square foot and another $3,000 per square foot. The difference is just puffery. Boston, Miami, Chicago, Los Angeles and a host of other cities have seen condo and house prices rise many folds. It was quite common to see condos priced at more than $1,000 per square foot. One million dollars did not buy much.

Due to massive investor speculation, and not population or income growth residential real estate in many US cities reached unsustainable levels. In Miami specifically, it has been said that over 60% of the pre sold condominiums were bought by investors. These "investors" in most cases intended to flip their units prior to closing. In some new projects, units were flipped many times prior to closing. This is a recipe for disaster. In California, all condos sold from floor plans or prior to completion are binding on the builder but not the buyer. This is a terrible policy. In effect, what happens is a speculator buys dozens of units, but chooses to close only on the few with the largest profit.

This policy actually causes a supply destabilization with huge numbers of unsold condo's left over at completion. The developer is left holding the bag. Additionally, because most American cities have only recently started building condominiums within their urban centres, construction trades, basic labour, supplies and techniques have not yet been developed to handle the onslaught. The result has been spiraling construction costs. Of course, due to the current slowdown in demand, a supply increase has been created that without a doubt has started to affect pricing. Real estate prices will soften in the United States until the supply and demand of housing becomes more balanced. Remarkable, a large city like Philadelphia absorbs less than 1000 new units per year. How large a supply glut can take place in Philadelphia with so few condo housing starts? This is typical of most US cities. The high-rise market is new and not really fully developed. Absorbing the current surplus will take months, not years.

The US economy is suffering from body blows taken from many areas. The war in Iraq and Afghanistan is costing billions of dollars per year. The US trade deficit is currently running at $247.7 billion per year. The federal deficit has ballooned to $318.7 billion in 2005 and the total debt now stands at $8.59 trillion (17 times more than Canada, a country ten times smaller by population). Additionally, inflation is now running at 2.6% and interest rates on a 30 year mortgage have risen to 5.85%. Americans have basically depleted their savings to an all time low of -0.2%. However, do not be misled despite all this, the US is in pretty good shape. Personal wealth is at an all time high, there are more millionaires and billionaires than ever before. Corporate profits and available investment capital are both overflowing. Growth rates for the economy are unlikely to turn negative or into recession. In short, the turbulence due to economic factors is not going to keep the real estate market down for long.

Iconic cities like Miami, New York, Chicago, Los Angeles, Boston and Las Vegas are international hotspots (except for Boston which benefits from lack of available real estate). These cities will be not be kept down for long. Americans and the world love these cities and the safe haven nature of their real estate. Don’t expect mansions in Beverly Hills to be reduced any time soon. In short, there is no safer place in the world to invest than the United States. So how will the Canadian market or more specially the Toronto condo market be affected by US slowdown? Firstly, Canadian banks lend on a maximum term of 10 years, not 25 like the US (a more conservative approach ensures few bank failures). Our interest rates were significantly lower than those in the US, obviously making real estate more affordable. Except for Calgary and Vancouver, all Canadian cities have experienced a moderate 3-4% growth in value year over year.

In the case of Toronto, prices have just returned to 1989 levels again, not adjusting for 17 years of inflation. Vancouver’s stratospheric prices are due to a low supply of land. Calgary’s hot market is due to a 15% annual economic growth rate. In Toronto, the contracts forbid an investor firm from flipping their units. Additionally, due to restrictions created by developers, investor purchasers are forced to provide 15-25% deposits, and the quantity of unites they can buy is usually limited. In any case, the number of investors in any project is rarely higher than 20%. Banks will not lend construction financing until a building is 70% sold, essentially covering 100% of their loan. Then banks insist on a buyer financing commitment letter for every sale. By the time the concrete starts to pour, the project is usually 75-80% sold out.

Virtually every project built is 95% sold out by registration and closing. The Canadian economy could not be in better shape. A 5 year mortgage is going to cost just over 5%. Interest rates are incredibly low, and this is after 7 consecutive increases totaling 1.75%. The unemployment rate is holding at 6.2%, inflation is 2.4%, and economic growth was 3% in 2007. All the provinces save; PEI, Nova Scotia and Quebec are now earning surpluses. The Federal Government will earn a massive surplus of $13.5 billion for 2006. The GST is not 5%. The dollar is at US parity. We are in the best financial shape of all the G-8 countries. The economy is close to full capacity utilization. The “have nots” of Newfoundland and Manitoba are going gangbusters. In short, it’s hard to see how things could turn ugly when they have never been better. This is a golden time for Canada.

Canada will double immigration totals from 250,000 per year to 500,000 per year. Over half of these people will come to the GTA. The Toronto metro population is currently 2.7 million people (the GTA is 5.2 million), it will cross the 3 million mark by 2010. We are one of the fastest growing first world cities on the planet. Housing requirements will continue to cause real estate shortages in Toronto for a long time. Additionally the children of the baby boom (the Echo generation) are now buying real estate. There are almost as many of them as were their parents. Look out for an explosive condo boom as these kids enter the market. Vacancy rates for condos have dropped to virtually nothing despite 15,000 new condo units having been completed last year. Currently less than 500 condos are for rent on the Toronto Central MLS underlying the need for many more rental units.

While there is no question that the US market is slowing down, it doesn’t look like Canada’s real estate situation is going to be greatly effected. Except higher prices and continued bidding wars for a while to come.